Examples of an equal-weighted index include the Standard & Poor's 500 Equal-Weight Index, which the Rydex S&P Equal Weight ETF (NYSE Arca: RSP) tries to reflect, and the Wilshire 5000 Equal-Weight Index.

Because the various stock capitalizations are held equally within the indexes, mid- and small-cap companies have a greater impact on the overall performance of an equally weighted index than they do on a market-cap-weighted index.
Consequently, equally weighted indexes have historically done quite well when market environments favored small-cap firms. In addition, mid- and small-cap companies usually do better over the long term and equally weighted indexes will most likely reflect the better long-term performance. Still, the so-called small-cap premium often takes many years to assert itself.

To ensure that the index holds an equal weighting on each component, the index may have high turnovers since stocks that performed well may be trimmed and those that have not done well will be bought. ETFs based on an equal-weight methodology may charge higher fees since the ETF incurs trading costs each time the fund rebalances. Additionally, equal-weight ETFs may also experience more bumps along the road due to the fund's larger weighting in volatile small-cap stocks.

Fundamental-Weighted Indexes
Rob Arnott of Research Affiliates argues that fundamentally weighted index portfolios outperform the cap-weighted S&P 500 over the long term because market-cap-weighted indexes are inefficient, which would lead to underperformance and lost opportunities.

The FTSE RAFI US 1000 Index is an example of a "fundamental" index that weights the 1,000 components based on current quantitative data, which includes a rules-based model with fundamental factors on sales, cash flow, book value and dividends. Arnott believes that a cap-weighted index overweights stocks that are above their fair book value and underweights companies that trade below their true fair book value, which may result in reduced returns on the market-cap-weighted index.

Invesco PowerShares recently overhauled some of the existing ETFs in its Intellidex series and added them to the RAFI Fundamental U.S. Series based on the Research Affiliates Fundamental Index methodology. The "fundamental pure style ETFs" weight companies based on a stock's financial size in order to diminish price distortion and provide a greater objective representation of the market.

Tracking Error
Advisors focus on the benefits of ETFs-transparency, low fees, intraday liquidity and so on-but if the ETF falls short of its benchmark index, they lose their advantage over active mutual funds and those ETFs that do track their underlying benchmarks. Passive or indexed investing is often a game of inches.

ETF investors should monitor tracking error in ETFs, since any lag between the fund and the benchmark could translate to losses in returns. A tracking error may be caused by any number of factors, including stocks with less liquidity, fund fees, optimization strategies, changes in indexes, dividend reinvestment requirements and the legal requirements a fund must follow.

The recent proliferation of ETFs with niche investment strategies cover areas where trading is less liquid. For instance, international and global ETFs will more likely see a greater disparity between their prices and their net asset values because the ETFs try to provide exposure to markets that are difficult to access, which tends to lead to higher fees and a heavier emphasis on optimization strategies. In contrast, U.S. equities-based ETFs more closely reflect their underlying indexes as a result of lower expenses and the relative ease in which the funds may access the underlying assets.

The Benefits of Index ETFs
Because of the passively managed investment styles found in index ETFs, the costs tend to be lower. Fund managers would only monitor any changes in the weightings of the underlying index and rebalance ETF holdings accordingly.